Brexit Bounce: What We Know About Market Risk

Brexit, England, UK

Until it did, no one really seemed to believe what happened could happen.

The sheer unlikelihood of the Brexit result – after the opinion polls, the financial markets, and the Barking Road betting parlors had all eagerly anticipated a comfortable “remain” win; and despite the instantly-borne financial carnage it wrought – the S&P 500 sank -5.7% peak-to-trough, the U.S. 10-year Treasury bond slipped from 1.74% to a low of 1.43%, the British Pound tumbled 12% to 1.322…the list goes on.

The market’s bluster turned out to be that of a carnival barker as the S&P 500 methodically snapped back 5.1% from its immediate, post-Brexit Monday low, and now, just four days later, the market sits within 100-basis-points of where it began on the day of the June 23 referendum.

Brexit was covered with the fervor of a hurricane and the hype of the super bowl.  It was living proof of life’s connectedness; one where 1.2 million U.K. citizens could perchance decide the fate of the markets and your investments.

Markets Crashes Can and Do Often Rhyme

The post-Brexit market action was eerily similar to the August 2015 Chinese yuan devaluation in that the S&P 500 fell hard on day one, languished lower on day two, and rebounded and recouped the majority of loses on days three and four.

"In financial markets, panic mostly creates opportunity simply because the hysteria directly affects an asset’s price not necessarily its value."

- Larry Shover, CIO SFG Alternatives

Brexit was different than August 2015 in that it was a market “surprise” whereas the yuan devaluation was met as a market “shock”.  This surprise versus shock is most apparent when comparing the pre and post VIX (the “fear index”) levels.  During the summer shock of 2015, the VIX index soared from a complacent sub-13.00 level to near 40.00 – all in one day!  Compare that to pre-Brexit where the VIX was trading at a slightly elevated 17.00 area and then post-referendum spurted to a very unceremoniously level of 26.00 before falling back down.

Investors Want Justification, Comforted by Answers

Musty feature stories including “Grexit”, “U.S. Credit Ratings Downgrade”, “Disinflation”, “Swiss Franc Unpegged”, “Yuan Devalues” fill newspapers. Stacked one on top of the other, it would be both fitting and wise to marvel about just how high the paper pile will rise before tipping all over  the floor.  For the time being the phony “expert opinions” of a post-Brexit world – i.e. worldwide market crash & depression - can be buried alongside their Elvis sightings near the site of the faked NASA moon landing.

Soon after the bounce-back, undoubtedly you will hear the “why did the market rally” questions hang in the air similar to some unexplained equation of general relativity requiring an Einstein to unravel its mystery.

Corrections Alter Asset Prices, Investors Alter Value

In financial markets, panic mostly creates opportunity simply because the hysteria directly affects an asset’s price not necessarily its value.  Panic has an irreducibly seductive power - luring investors to be handcuffed by their emotions which are dangerously reinforced by the financial media complex.

Combine this with high-frequency and other non-fundamental trading programs risk-limits which are all sparked by losses and increased correlation, will complete the self-fulfilling prophecy of selling at any cost without regard to valuation or fundamentals.  This is precisely why we investors are so often duped into “buying high” and “selling low”.

A General Misunderstanding of Decision-Making Ability

One of investor’s widest blind spots is a general self-confidence in constructing the future; spending little time in backward engineering the countless pathways our decision could take us. Certainly, some are better than others at guessing a general direction of a stock.  A great talent to possess but that’s strictly binary – a simple right or wrong.  To be confident in your future decision making is a fool’s game.  We are outmatched by a team of infinite combinations.  So instead of building an investment portfolio based on your premonition, be instead relentless in building a portfolio that compensates for your blindness which is far greater than any of us could imagine.

In 1588 bloated cargo holds that bogged down Philip II of Spain’s fleet proved themselves no match for England’s nimbler sea vessels.  Although a decisive Spanish defeat was ultimately had, England’s Captain Drake could not take credit for the treacherous Northeasterly gale that whipped the Spanish Armada onto the treacherous coast of Ireland.

The question is: Was this monumental historical moment due to faulty planning, poor risk-management, over-confidence, or plain-and-simple randomness?  The answer is a resounding yes, it was all of the above. The same holds true with our investment portfolios: We just do not know what we do not know.